What the Heck is PPI and Why Should I Care?

Since PPI is being released tomorrow, I thought I would talk about it. I was in a doodling mode so I created some pictures and graphs to help you from falling asleep since the subject of PPI is a natural sleeping pill.

What is the PPI? What does it measure?

The Producer Price Index (PPI) measures the rate of inflation experienced by manufacturers. The reading represents the monthly change in the average price of a fixed basket of goods purchased by manufacturers. Higher inflation generally leads to higher interest rates, which tends to strengthen the country’s currency.

It sounds like CPI, what’s the difference?

PPI is an index of commodity prices. In contrast, the CPI measures the prices of both commodities and services – housing, transportation, medical, and other services almost make up 50% of CPI. The CPI also includes imported goods while PPI does not.

Another difference between the CPI and PPI (for finished goods) is that PPI measures the cost of capital equipment purchased by businesses.

What’s in this “basket of goods”?

Consumer-related goods account for 75% of the pie. Consumer goods, mainly cars (aka whips), represent 40%. Consumer foods provide an additional 26%. Within consumer foods are prices for meat and fish, dairy products, and fruits and veggies. And the energy category, mainly gasoline and fuel oil, represents an additional 9% of the index. Within the capital equipment category, which accounts for the remaining 25% of the PPI, cars and trucks play a major role. You probably noticed that automobiles are counted twice. That’s because businesses purchase automobiles as well as consumers.

How is the data put together?

What is Core PPI?

Many economists look at the PPI excluding food and energy which is called core PPI. Why? Because food and energy prices tend to be extremely volatile. Energy prices maybe influenced by the weather such as when Hurricane Katrina damaged most of the oil refineries in the Gulf of Mexcio and affected oil production The same goes for food also. A drought could increase prices for a long period of time. This is why it’s important to isolate such spikes in prices to see PPI’s true inflation path.

How do “professionals” look at PPI?

The “professionals” generally look at PPI in a broader context and will consider several approaches:

Compare the most recent month to the prior two to three months

Look at the moving average of PPI releases for the past six or twelve months

Determine year-over-year inflation rates

The point here is that you shouldn’t read too much into an isolated report. It’s better to identify a trend and decide whether a new direction is occurring.

How does PPI affect the US dollar?

The dollar tends to strengthen on rising short-term interest rates. So if the Fed is raising rates,this is dollar bullish. This is especially true if US interest rates are moving higher when compared to other countries’ rates. This is called the interest rate differential.

So if a high inflation number is reported, the dollar will usually rise, since this provides the Fed a reason to raise interest rates.

Look at my sketch below.

If PPI is rising or higher than expected, this means there is inflation risk from the manufacturers’ side, and provides the Fed with data that’s supportive of raising interest rates (raise dem rates yo). This is dollar bullish.

If PPI is falling or lower than expected, this means there is little or no inflation risk from the manufacturers’ side, and tells the Fed to lower or at least quit raising rates (quit dat rate hike yo). This is dollar bearish.

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